Kellogg (K)

Q2 2010 Earnings Call

July 29, 2010 9:30 am ET


Kathryn Koessel -

John Bryant - Chief Operating Officer and Executive Vice President

Ronald Dissinger - Chief Financial Officer and Senior Vice President

A. D. MacKay - Chief Executive Officer, President, Director and Member of Executive Committee


Alexia Howard - Bernstein Research

Judy Hong - Goldman Sachs Group Inc.

Vincent Andrews - Morgan Stanley

Jonathan Feeney - Janney Montgomery Scott LLC

Christopher Growe - Stifel, Nicolaus & Co., Inc.

Terry Bivens - JP Morgan Chase & Co

Eric Katzman - Deutsche Bank AG

Robert Moskow - Crédit Suisse AG

David Driscoll - Citigroup Inc

David Palmer - UBS Investment Bank


A. D. MacKay

Thanks, Kathryn, and good morning, everyone. Our second quarter results were modeled and expected, reflecting weakness in the Cereal category, combined with the impact of our voluntary cereal recall at the end of June and softness in that area of business.

The weakness in the Cereal category have the greatest bearing on our Q2 results. Throughout the first half of the year, we talked about the challenging Cereal category and deflation. Our results and those of other cereal manufacturers reflected this trend.

Although we anticipated a difficult quarter, the severity of the impact to our business was greater than we expected. Our low cereal sales resulted from difficult year-on-year comparables, the cereal recall and inventory reductions. John will talk about these in greater detail.

We continue to feel confident in the Cereal category and believe trends will begin to improve in the back half of the year. Let me talk briefly about the voluntary cereal recall, which was due to an item that came from the line up. While we had relatively few complaints at the time of the recall, we knew that removing the production store shelves was the right thing to do for our consumers. The cost was high, the total anticipated EPS impact for the year including lost sales is approximately $0.12. And we're currently pursuing all legal recourse to recoup the cost.

Over the past 18 months, we've experienced two events that have adversely affected our business. The payment-related recalls at the end of 2008 and the recent cereal line of recall. We're frustrated by these business disruptions, both supply related, but I can confidently say that they were unrelated to one another and unrelated to our cost savings programs. And when it comes to quality and food safety, over the last few years, we've actually increased our vigilance and ramped up our investment across the company.

What these issues do have in common is the pressure that they place on our resources, both time and money. While we're working to minimize the impact, they will cause disruption to our business, our employees, our customers and our consumers and to this quarter, to our total company results. The weakness in our Cereal business in Q2, combined with the size of the cereal recall, drove our decision to call down our 2010 guidance.

It has always been our intent to take a realistic, open and pragmatic approach to running our business for the long term. This call down, while disappointing, will ensure that we can continue to do the right things for the long-term health of the business. As we said at the beginning of this year, we expect a stronger back half as we anticipate category trends will gradually improve. Of course, this will not happen overnight. We also expect to have stronger innovation in the second half of the year.

We just introduced FiberPlus cereal at the end of June, with strong initial results. And our Snacks business has launched a strong line-up as well. And we will continue to invest in our business through increased advertising. John will review the business in more details shortly. Even though we had a tough quarter, we feel good about the underlying health of our business and the remainder of the year.

And with that, I'd like to turn it over to Ron to discuss our financials.

Ronald Dissinger

Thanks, David. Good morning, everyone. Let me begin with a summary of our second quarter and first half results on Slide 4. As we have mentioned, we expected to have some tough comparisons in the first half, as well as some challenging operating conditions across our business. What we did not anticipate was the degree of weakness in the Cereal category and, of course, the voluntary cereal recall in June that directly impacted our results.

For the quarter, net sales declined 5% on a reported basis and 4% on an internal basis. Approximately one point of the sales decline was attributable to the recall. The softness in the Eggo business also contributed roughly one point to the decline in sales. The remainder was primarily due to weakness in our U.S. and U.K. Cereal businesses and the reduction of cereal inventory levels in the U.S.

Operating profit for the quarter also fell as a result of lower net sales, the recall and an increased investment in advertising. Operating profit was down 13% on a reported basis and down 11% on an internal basis.

Earnings per share declined 14% on a reported basis, and 11% on a currency-neutral basis. The recall reduced operating profit by approximately 10% and earnings per share by $0.10, including loss sales in the quarter.

As we look at recent consensus estimates, we recognize that it was difficult to estimate the impact of the recall, given that we provided no guidance until today. The accounting rules required us to book the majority of the impact in the second quarter. We also expect a small impact in the third quarter.

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